Room to Move (Redux)

Layna Mosley, one of my professors at UNC, has a piece in Foreign Affairs on the European sovereign debt crisis. In a sense she's come back around to her dissertation work, in which she argued that international investors care much more about outcomes than the particular policies used to generate those outcomes, or things like the partisan composition of governments. Turns out that she was pretty much right about that, at least in the case of Europe.

She has two primary points. The first is that the composition of debt maturity matters quite a lot; a lot of short-term debt means a lot of servicing, which means a greater sensitivity to short-run developments. The second is that investors don't have nearly as much influence on government policies as most commentators ascribe to them. What influence they do have is, again, over outcomes rather than the particular decisions used to reach them. So yes, investors prefer lower debt levels, but they don't particularly care whether fiscal probity is achieved via spending reductions or taxation. Mosley previously referred to this relationship as giving governments "room to move": so long as they stay within certain parameters -- mostly relatively low/stable inflation and relatively low/stable debt levels -- governments have quite a lot of latitude to pursue other policies without being punished by investors.

It's a good piece with valuable lessons. Read it.

Definitely Not Expansionary, Maybe Not Even Austerity

Dan Drezner has a post on whether we are now at a focal point that will discredit the idea of expansionary austerity:

The Greek sovereign debt crisis was another such focal point. Greek profligacy seemed to be a synecdoche for excessive government borrowing and lax fiscal discipline. With the global economy seemingly still in the doldrums, a lot of Europrean governments climbed on the "expansionary austerity" bandwagon. By the Toronto G-20 summit in June 2010, the consensus had switched from Keynesian stimulus to fiscal rectitude. Oh, sure there were mutterings about "short-term austerity makes no macroeconomic sense whatsoever in a slack economy" but even Barack Obama started talking about slashing government spending. 

Are we at another focal point? Consider the following: 

1) According to the New York Times' Stephen Castle, European leaders now seem to recognize that austerity on its own ain't working... 

2) The data is starting to come in on governments that have embraced austerity whole-heartedly, and it's pretty grim. Cue Paul Krugman on Great Britain:... 

3) Even commentators who would be tempermentally sympathetic with austerity are starting to bash Germany question whether it's a solution. Consider Walter Russell Mead:...  

4) U.S. 4th quarter data reveals that, consistent with GOP criticisms, the government has been the real drag on the U.S. economy. Not quite consistent with GOP criticisms: the reason why the government is dragging down the U.S. economy. Cue Mark Thoma:...

Before I get into this too deep, I should just note that I've always thought the accusations of belief in "expansionary austerity" from the Krugman/DeLong wing have always been something of a strawman.  The strongest view I've seen regularly expressed is that fiscal policy has essentially a null effect on growth because of forward-looking rational expectations, or because the central bank moves last, not that austerity will actually lead to expansion. I haven't even seen much supply-side voodoo being expressed lately. Can't recall the last time, actually.

First of all, I'd quibble with the claim that the G-20 ever climbed on the "expansionary austerity" bandwagon. Look at the Toronto Summit Declaration that Drezner mentions. No seriously, read it. There's a lot of language like "Unprecedented and globally coordinated fiscal and monetary stimulus is playing a major role in helping to restore private demand and lending" and "To sustain recovery, we need to follow through on delivering existing stimulus plans". Here's the first thing it says about budget deficits (emph added): "At the same time, recent events highlight the importance of sustainable public finances and the need for our countries to put in place credible, properly phased and growth-friendly plans to deliver fiscal sustainability, differentiated for and tailored to national circumstances."

To be fair, the next sentence advocates "consolidation" for countries with "serious fiscal challenges", but does that sound like doctrinaire Treasury View economics? Not to me, and certainly not for anyone outside of Club Med. And while Obama started talking about cutting government spending as Drezner notes -- not sure "slashing" is at all the right word -- other than token cuts all of the significant stuff was reserved for a few years down the road when the recovery was expected to well in progress. The Obama administration also thought in 2010 that growth was taking off; remember "Recovery Summer"? If they'd been right, it would be time to start thinking about cuts in the shortish-run future.

As for European views, it's possible that some people thought Greece's short run growth potential would benefit from austerity, but I don't remember much of that. After all, austerity is called austerity for a reason. All the talk I heard was about austerity as a sufficiently strong commitment mechanism that donors from the EFSF and IMF could be convinced that their transfers to Greece wouldn't be squandered, nor that they would be embedding moral hazard into the EMU that would encourage future profligacy. Now that may not be the best possible economic strategy, but this is a political game not an optimization problem, and in any case it doesn't follow from this observation that anyone believed that austerity would lead to expansion. The Germans cared about getting their money back, not generating growth in Greece, except to the extent that the two are related (and maybe not even that much). My recollection of the early discussions was that if European leaders believed in any of Krugman's oft-mentioned myths it was the "Confidence Fairy", not expansionary austerity.

And, while we're on the subject, the most recent proposal is for lots more austerity for Greece, with Germany taking over Greece's political system if they can't manage that themselves. It doesn't sound like the austerity consensus is at risk of breaking.

Regarding Great Britain and the United States, I'm not sure that the "austerity has failed" line is all that accurate. Here's Scott Sumner:

Here are the three biggest budget deficits of 2011: 

1. Egypt 10% of GDP 

2. Greece: 9.5% of GDP 

3. Britain: 8.8% of GDP 

A slightly more respectable argument is that the current deficit is slightly smaller than in 2010 (when it was 10.1% of GDP.) But that shouldn’t cause a recession. Think about the Keynesian model you studied in school. If you are three years into a recession, and you slightly reduce the deficit to still astronomical levels, is that supposed to cause another recession? That’s not the model I studied. ...

To get a sense of just how expansionary UK fiscal policy really is, compare it to France (5.8% of GDP), Germany (1.0% of GDP), or Italy (4.0% of GDP). Lots of people blame ECB policies for the recession, but Britain is not in the eurozone. Outside the eurozone you have Denmark (3.9% of GDP), Sweden (zero), Switzerland (1% surplus).

In other words, any "cuts" in spending have to be considered in context. Britain's cuts were from an insanely-high (and completely unsustainable) level to an exceptionally-high (and completely unsustainable) level. You can call that "austerity" if you like, and blame the lack of recovery on it if you like, or you could say that Britain has run historically high deficits in each of the last few years. Which is, pretty much, the opposite of austerity. (In any case, Cameron's administration knew that these cuts would not be expansionary, estimating that they'd cost more than a million jobs over five years.)

Similarly, with regards to the United States, Kevin Grier notes that "Federal spending is still [sic] than 30% higher than it was in January of 2007. State and Local spending is still around 12% higher than it was in January 2007. Is this really austerity? ... Can we really run a trillion dollar deficit and bemoan austerity simultaneously?"

I would tend to answer that question with a loud "No".* "Austerity" does not mean "not spending more on infrastructure". "Austerity" does not mean "not enacting a major jobs program". The U.S. did not continue to use fiscal stimulus at the same rate as the emergency measures taken in 2009, but that doesn't mean there's been all that much retrenchment. We haven't stopped mailing the food stamps. We haven't cut off Social Security payments. We haven't raised any taxes, and have cut quite a few. How is that austerity? Maybe that's not enough for Krugman's your taste -- and in fact I'd support higher deficits right now -- but fiscal transfers are political choices, subject to political pressures. Doing more now implies a greater burden for certain segments of the population later, and Obama's continued pursuit of a "millionaire's tax" and "Buffett rule" and "TBTF tax" and corporate tax reform and international corporate minimum tax just drives that point home.

So upper-income Americans don't have to believe in expansionary austerity to oppose further deficit spending; they just have to realize that when the bill does come due they'll be the ones paying it. They couldn't care less whether the fiscal multiplier is greater than 1 or not, because they won't be getting most of the benefit but will be paying almost all of the cost. Substitute "Germans" for "Upper-income Americans" and you're describing the Euro-crisis as well.

Drezner refers to an austerity "gospel", but I'm not seeing all that many true believers. I see it more as a competition between interests.

*Perhaps ironically, so does Krugman. From the article Drezner links: "True, the federal government has avoided all-out austerity" although he contradicts Grier by saying right after "But state and local governments, which must run more or less balanced budgets, have slashed spending and employment as federal aid runs out — and this has been a major drag on the overall economy". Grier provides data, so I'd tend to believe that he's more right, but Krugman usually doesn't make that sort of error so maybe a more nuanced perspective is needed.

Global Financial Markets FOTD

Major U.S. banks have about $80bn in exposure to troubled European sovereigns, about $30bn of which is protected via CDS. Think $50-80bn is a lot? It is. But remember that TARP was a $700bn program. Remember that the Fed will hold interest rates at zero percent through 2014. Remember that these same five banks control over $9tn (with a 't') in assets. $50-80bn isn't very much for these companies.

Yes, there is still secondary risk from a sovereign default tipping over European banks, which then hold up U.S. banks. That's not nothing at all, but isn't everything either: unless it's a huge event, large enough to take down all the big banks in Europe, then I wouldn't be exceptionally worried about it. And if it's that big then there's likely nothing you can do about it anyway.

The European mess is mostly a European mess. We're not nearly as susceptible to them as they were/are to us.

(ht: @EconOfContempt)

Baking Banking Instability into the European Cake

Apologies for the long absence. The past few weeks have been extraordinarily busy on several fronts. I think I'll be able to get this place back into fighting shape pretty quickly.

The decision of S&P to downgrade more or less the whole of Europe has made a lot of headlines, but I'm not sure how much it matters. The plan for Europe before that happened isn't much affected by the downgrade: the ECB prints money and gives it to the banks, accepting EMU sovereign debt as collateral. The banks use the funds to buy sovereign debt. The banks get financing for sure, and if all goes well so do the governments. As far as I can tell, for regulatory purposes all OECD sovereign debt still counts as "risk-less" -- meaning that banks are not forced to hold any capital against it -- under the Basel accords, so there is a regulatory incentive for banks to buy some of this stuff.

There's something absurd about all of this... every step in the chain is an attempt to hear no evil by sticking fingers in one's ear. But if the eurozone is going to survive the European banking system has to stand upright and be able to finance governments. That requires ECB support.

JP MorganChase CEO Jamie Dimon, who often says things in public that are more revealing than he perhaps realizes, recently claimed to believe that there is no banking problem in Europe:

“It eliminates bank liquidity or funding problems for at least the next year, that’s a pretty powerful statement,” Dimon said today after his company reported a drop in fourth-quarter net income. “That was the biggest single risk of an uncontrollable surprise right there, so if that’s taken off the table, that’s a good thing.” ... 

“Europe is trying mightily to solve its problems. I still think the likely outcome is they will muddle through,” Dimon said. “The longer you wait, the higher you run the risk of something disorderly that you can’t really control. I think the ECB took off the worst outcome, i.e. a bank failure.”

Dimon might be right about Europe being able to muddle through, although I still have my doubts. He might even be right that a bank failure is the "worst outcome" in Europe, although I can think of some worse outcomes. But what he doesn't say, indeed what no one has much talked about, are the negative effects this will likely have in the European banking sector if the plan works.

The problem that the new ECB policy is supposed to resolve is this: banks won't lend to needy European governments except at punitive rates. Why? Because those governments are highly likely to default. This is exactly what we want a responsible, healthy banking sector to do.* What we don't want is what we're now hoping to get, which is to say that we don't want a banking sector whose investment behavior is skewed by political institutions pursuing dubious policy goals. We don't want a banking sector that has an expectation of future support if their investments go bad, and we don't want a banking sector that cannot discipline either itself or those to whom it lends.**

We don't, in short, want a situation in which government interventions make Jamie Dimon smile. (Or interventions that make him rich.)

Is this road less bad than the one Europe was on previously? In short run, surely. In the medium-to-long run it's hard to say. Perhaps we think that once the crisis is resolved the ECB can make a credible future commitment to be more standoffish towards the European banking sector. Perhaps we think that we can rein in banks and national governments in other ways, via strict capital standards for the banks and "Hard Keynesianism" for the governments. But I have little confidence that those things are likely. They cut against almost every identifiable political current.

The only way it works is if this crisis really scares everybody so much that a significant (and durable) shift is made in the regulatory and fiscal infrastructure of Europe. While not impossible, I remain highly skeptical that that will happen. I believe it's more likely that policymakers will conclude that the institutions in place are pretty resilient already -- "How else could we have pulled through this crisis?" -- particularly when coupled with a more activist ECB that will support the banking sector when needed.  I believe the banks will conclude that the ECB is their friend, and will therefore count on support when needed, particularly if the cause of the trouble are the member nations of the EMU. That is a recipe for a lot of future financial instability.

The ECB cannot, and should not, be in the business of resolving Europe's political problems. Forcing it into that role is likely to make things worse in the long run.

*The "we" here being an imagined societal consensus in possession of the general will, which reflects more-or-less center-left neoliberal technocratic principles. Yes, I know this "we" does not exist in nature.

**I have a paper, currently R&R, that argues that when banks expect preferential policies from governments they act less prudently. Simple argument, I know, but it's not in the literature yet. I find statistical support. I'll post it if/when it gets accepted somewhere; if someone wants it sooner e-mail me.

Keep It Simple

Hey! Megan McArdle! Maybe the OECD governments that negotiated the Basel accords assigned a zero risk-weight for OECD sovereign debt because they wanted to incentive banks to buy their debt at low interest rates. And maybe banks complied because they assumed that they'd get bailed out by somebody if those bets ever went bad.

It wasn't about mistakes made while "risk engineering". It was simple political economy.

The Argentinian Euro Deal

Markets seemed to like it yesterday, not so much today. You can find news and discussion of the plan everywhere. I liked Salmon's takes here and here.

Like many others I'm skeptical that it will work. Interestingly enough I'm currently reading Paul Blustein's very good And the Money Kept Rolling In (and Out) about the IMF's relationship with Argentina around the turn of the millenium. The parallels between Argentina and Greece are striking -- I'm not the first to notice this -- but the parallels between the IMF and EU actions are also notable. Let's run down some of them.

1. At the time Argentina was on a convertibility system with the peso was pegged one-to-one to the US dollar. This is functionally very similar to the European common currency, where "Greek" euros are pegged one-to-one with "German" euros. Both systems were adopted for similar reasons: national authorities were not able to credibly commit to stable monetary policy, which led to a lot of economic volatility, investment risk, and concomitant slow growth. In both cases macroeconomic adjustment is impossible through the exchange rate, which leaves internal devaluation (i.e. austerity) and/or debt default as the only remaining options.

2. Both policies worked well for about a decade. Because of that, the Argentine and Greek governments were able to borrow at low interest rates. And because of that, governments were fairly casual about fiscal probity. While public deficits were not extreme, they were politically entrenched. When growth began to slow lower tax revenues led to a growing debt burden. Interest rate spreads widened as investors began to believe that both economies would not be able to grow fast enough to manage their debt. This, of course, can become a self-fulfilling prophecy. Both governments were voted out of office, both new governments instituted fiscal reforms. In both cases these were insufficient to close the budget gap. In both cases the cost of incurring new debt, or of servicing old debt, became prohibitive.

3. In Argentina, the IMF began disbursing relatively small amounts of money in the hope that external financing would reassure bond markets. In other words, the IMF hoped that it was a liquidity crunch, not a solvency crisis. In that situation a tie-over loan can buy time for the economy to get some growth back. The EU did the same thing with the introduction of the EFSF. But the underlying economic numbers didn't improve, and bond markets continued to believe that issue was over solvency, not liquidity.

4. Politics intervenes. In Argentina, the US (and other key IMF members) were hesitant to offer additional financing as they had done during the Tequila Crisis. In particular, John Taylor -- then at the Treasury Department -- didn't want to throw US funds into the pot. Neither did Glenn Hubbard of the CEA or Paul O'Neill, the Treasury Secretary. In Europe, many members were reticent to commit more funds. In both cases policymakers tried to figure out how to leverage already-appropriated funds to have a greater effect, but nobody bought it in either case. (Ken Rogoff, at the IMF during the Argentina crisis, quipped "After one strips out all the window dressing, there is no way to make $6 billion of liquidity worth more than $6 billion in liquidity. But there are many creative ways to make it less.")

5. Then come the "voluntary" private sector haircuts, coupled with additional public funds. These are intended to do a few things: extend the timeframe that indebted countries have to consolidate fiscally, reestablish growth, force the private sector to bear some of the costs of bailouts, and thus prevent default in a politically palatable way. In both cases the initial market reaction was positive, but in Argentina the effect was short-lived and I expect that to be the case with Greece as well. Barry Eichengreen described the Argentina situation thus: "The realization had dawned that the IMF package offered no magic formula for getting growth going again. And without growth, it is hard to see how political support for paying the foreign debt can be sustained." This sounds a lot like Greece, no?

6. A corollary of the private sector haircuts, as well as extended financing from international institutions, is that the country actually becomes more indebted rather than less. This happens in two ways. The private sector demands some form of compensation in exchange for voluntarily altering the terms of their debt contracts; and the new financing from international institutions also tacks onto the principle. Additionally, it's more difficult to default on IMF/EFSF loans than private sector loans. Given that the optimistic scenario is that this deal will reduce Greece's debt load to 120% of GDP, and the fact that the fundamental problems -- low growth + high debt in a fixed-currency system -- have not been resolved, there is little reason to be optimistic about the outcome.

Ultimately Argentina's internal adjustment plans were undermined by domestic politics. Voters simply got sick of extreme austerity and revolted. That meant a debt default and the abandonment of the convertibility system. It's hard not to imagine a similar scenario playing out in Greece in the coming months.

Even if it doesn't, there's still Spain and Italy looming over the horizon.

The Selectorate in Theory and Practice

Bueno de Mesquita and Smith continue their guest-posting at the Monkey Cage with this, which basically describes how time inconsistency problems can affect politics. (Michael Lewis recently wrote a case study of this process in California which, for all its faults, is better than his essays on Europe.) Before I get into my criticism, let me say that I value their work on selectorate theory, even though I think it has some problems. I value it for a few reasons: because I think the dynamics they are trying to model (basically a formalization of a strand of public choice econ) are very important for the study of politics even if their theory isn't a finished product, and because they provide a central theoretical paradigm for other scholars to use as a foil for their own research.

Anyway, enough throat-clearing. As this post, and the titles of their books on selectorate theory -- The Logic of Political Survival and The Dictator's Handbook -- make clear, theirs is a theory of comparative politics, not international relations. Nothing wrong with that, but it leaves them susceptible to problems that scholars who primarily operate in one subfield often have when crossing over into another. Specifically, they tend to make assumptions that seem reasonable but are nevertheless highly contentious. This post illustrates one of them. BdM and Smith write:

It is certainly true that bankers and businessmen wrote loans they suspected would not be repaid; they buried debt on the balance sheet; and, in extreme cases, committed outright fraud. These actions, and hundreds of others like them, provide rewards today, accruing costs that must be paid in the future. Why run up so much debt? Easy, paying costs in the future is someone else’s problem. It certainly won’t be the executive’s problem if she does not survive at the top today. Business leaders happily – and smartly – mortgage their firm’s future to ensure that they retain control now. Lavish payments even when performance is poor is the norm, not the exception.  

As much as politicians chide business leaders, they too love debt. It lets them buy loyalty now. Repayment is some future leader’s problem. Politicians hate to pay as they go. They love to make expensive promises that they don’t have to fund. For instance, politicians love to pay public sector employees with modest wages and fantastic defined pension benefits. This means less to pay today on their watch and more to pay on someone else’s tomorrow. What could be better!

On the one hand this seems more or less incontestable: politicians would prefer to buy support now and have someone else pay later. As the theorize later in the post, autocracies are more prone towards debt accumulation than democracies. I'm sure this is true in many contexts, and Oatley has some recent research that backs it up, but the example they introduce as illustrative of the broader phenomenon -- the actions of bankers -- gives us reason to question their narrative. Bankers acted the way they did in part because of policies that rewarded this behavior. The financial sector profited enormously from the legal and regulatory structures in the United States and around the world over the past few decades, and there was always an expectation that the government would support them in times of trouble. The Fed made that guarantee via the Greenspan/Bernanke "put", and the fiscal authorities did as well, setting a clear precedent of interventionism through a series of fiscal interventions from 1980s-2000s.

In democracies the "selectorate" -- the group whose support politicians must maintain to stay in office -- is assumed by BdM/Smith to be 50% of the population, or near that number. And yet the most energized political movements on both sides of the ideological spectrum right now, the #OccupyWallStreet and Tea Party groups, both formed in large part in reaction to policies that benefited bankers over the masses. These policies were enacted by both major political parties in two different presidential administrations, and do not benefit 50% of the population. They benefit a very small minority of it, hence the "We are the 99%" slogan of #OWS. In general the economy of the US and other industrialized democracies has become much more unequal over the past several decades, and  there has been little or no movement towards redistribution to mitigate the trend. A more progressive tax system would definitely benefit more than 50% of the population, yet the government finds it very difficult to pass a several percentage point marginal tax increase on millionaires.

Not only can selectorate theory not explain this, it would predict the opposite. More generally it would expect the majority of the population in an increasingly-unequal society to favor highly redistributive policies, and it would expect politicians to respond to this demand. BdM/Smith might be on stronger footing if they adopted the Rajan thesis that the government countered stagnating median wages by expanding credit access, but even this would depend on the claim that 50% would prefer more credit to more income. This seems dubious.

It seems more likely, to me, that the idealized account of democracy that selectorate theory provides is incomplete. The strength of selectorate theory is that it can accomodate more complex accounts of preference creation and aggregation relatively painlessly, but the weakness of the BdM/Smith application of selectorate theory is that they seldom take the more complicated steps that are necessary to reach conclusions that match our empirical understanding of the world. That leaves us in a place where selectorate theory is potentially valuable if used with care, but the primary proponents of selectorate theory -- in emphasizing parsimony over accuracy -- end up reaching conclusions that are pretty clearly wrong.

EU Fiscal Union Is Highly Unlikely, con

Edward Hugh reports that the Germans are laying down the gauntlet on the Greeks:

Only yesterday, German Finance Minsister Wolfgang Schaeuble informed members of the parliamentary budget committee that Greece is now perched on a "knife's edge". This follows hints from other leading German politicians (including Angela Merkel herself) that a Greek euro exit is no longer the unthinkable taboo topic which it had been to date.  

As if all of this wasn't clear enough, the Dutch Prime Minister Mark Rutte suggested yesterday in an FT article that expulsion from the Euro Area should be available as a disciplinary measure of last resort.

For detail on why things are coming to head now, see the link. The gist is that the "voluntary haircut" component of the most recent Greek bailout isn't working the way it was intended, and neither Greece nor Germany (and other Euro creditors) are especially interested in yielding to the other at this juncture. They may continue to muddle through as they have previously, but hopes that the recent bailout-plus-haircut approach is going to be sufficient have been weakened.

EU Fiscal Union Is Highly Unlikely

Phil Arena was fishing for a post from me on Europe in response to this:

Europe appears to be inching closer to a more centralized fiscal union that would eventually turn the euro zone into something resembling a United States of Europe.

Today we have news that a German court has ruled that Merkel's actions to bailout other European countries were not illegal -- good news for Merkel -- but that any new funding must be approved by the German legislature -- very bad news for Merkel. And yet even Merkel does not approve of the sort of measures that would create a "more centralized fiscal union" in Europe. Her joint statement with Sarkozy on August 16 repudiated eurobonds, as well as an extension for the European bailout mechanism, the EFSF. Meanwhile voters in Finland (and other countries) are starting to assert themselves by demanding increased collateral from Euroborrowers before they approve of new funding. Any one of the 17 EMU members can veto any agreement, and it looks increasingly likely that one or more of them will. And not just the creditors... the debtors are angry too. (Most recently Italian workers went on strike to protest a new austerity package, following similar protests in Greece, Portugal, and Spain.) The EU banking crisis looks like it's spreading, placing even greater burdens on public sector balance sheets and economic growth rates.

Meanwhile, where is the constituency for a greater fiscal union? Perhaps Sarkozy wants that, but Merkel does not. Voters in the Eurocore do not, and it's not even clear that voters in the Europeriphery do either, at least if that comes with supranational authority to set budgets and intervene into macroeconomic policymaking. Which it surely would.

So I just don't see how a fiscal union is politically possible. And I don't even see why it's desirable. Or more precisely, I don't see who would desire it. So I don't see it happening.

(Nearly) Daily Reminder That Everything Is Screwy

Treasuries now more expensive than they've ever been:

Treasury 10-year note yields fell to an all-time low today as concern the euro area’s debt crisis will cripple financial institutions underpinned demand for the safest assets. A government report Sept. 2 showed no jobs were added in August, reinforcing concern the U.S. economy has slowed which may prompt additional stimulus by the Fed.

Wanna Bet?

“Politics cannot and will not simply follow the markets,” [Merkel] told German public television on Sunday in her first interview after returning from holiday a week ago. “The markets want to force us into doing certain things - and that we won’t do.”

That is in reference to eurobonds, which Merkel (along with 75% of German citizens) does not support. She understandably does not want to share Germany's credit rating with heavily indebted countries. But markets have been making Germany make political decisions for several years now, and that will continue. Merkel never wanted the EFSF. Merkel never wanted the compromising of the ECB. Merkel never wanted Germany to be on the hook for the whole eurozone. But markets have forced her hand at every juncture, and is still.

The current EU policy of muddling through is precisely about "following the markets". Intervention is only done when markets force the hands of EU leaders. This makes perfect sense in game theory where every intervention is unpopular with at least one set of voters. In such a model markets would not only influence politics, politics would be very difficult without them. The fact that markets can alter the equilibrium makes it a very important political actor. Anti-neoliberals may view this as a tragedy ("markets undermining democracy"), but recall that the problem has arguably gotten this dire because of too little bond market discipline during the 2000s, not too much.

Daily "Everything Is Screwy" Reminder

The Swiss government wants people to stop using the Swiss franc:

Yes, you read that right: if you want to lend Swiss francs or make a deposit in the next year, you must pay for that privilege, or so the Libor market implies. The normal assumptions of finance have been turned upside down; call it Alice in Wonderland economics. ...

What makes the Swiss situation so remarkable, however, is that it affects not just ultra-short rates. On Friday, futures markets predicted negative rates until 2013 (and minus 8 basis points next summer). This is unprecedented.

There is a huge surplus of demand for safe assets over supply. The Swiss government is not able or not willing to supply any more francs without getting something for it, because currency appreciation is killing their exporters and driving imbalances that could be painful to unwind. So maybe, just maybe, a much larger country with a much greater ability and capacity for the production of safe, liquid assets should do more to stabilize the international financial system.

In other words, the US should be much more in debt than it is.

ht: TC

Daily "Everything Is Screwy" Reminder

The United States government can borrow at negative yields out to 10 years. 1% out to 30. And the response to that? A downgrade, and both political parties freaking out about borrowing.

To twist the (stupid) expression common among politicians, if the US government were a household we would not have to live within our means, because other people are willing to pay us to take their money. And if we ever were faced with a situation in which we had to pay, we can always just create new dollars ex nihilo. Which only households with money trees in the backyard can do.

And yet we do nothing. Is there any historical analogue to this?

S&P and Exorbitant Privilege

Layna Mosley, one of my professors here at UNC, has a guest-post at the Monkey Cage on the sovereign debt downgrade. I'm not going to excerpt much as it's worth reading in full, but I want to highlight a few things. First:

[O]n the basis of just its fiscal statistics, the U.S. would have been under pressure to accept an IMF program long ago. Of course, there are many differences between the US and the typical IMF borrower; the broader point is that the US can’t necessarily expect its “special” status vis-à-vis markets to persist indefinitely.

I think the "many differences" part is really key here, as Layna gets to a bit further down:

In the U.S. case, the fact remains that Treasury securities are a favored “flight to safety” instrument for investors worldwide. When risk acceptance and global liquidity is high, investors look for high-risk, high-return assets – equity offerings in emerging or frontier markets, for instance. But when risk aversion is high, investors seek out safe havens. Treasury bonds have long been such a haven, both for domestic and foreign investors. Many holders of U.S. government securities are official entities (such as foreign central banks), while others are private investors.

What other options do these safety-seeking investors have? There’s the Swiss franc. And there’s gold. Both have experienced surges in prices that come from the search for safe investments. But where else might investors go? Certainly not into euro-denominated instruments, given the continuing crisis in the euro-zone. And probably not into renminbi-denominated instruments; for all of the speculation that the dollar’s “exorbitant privilege” is reaching its end, don’t expect it just yet.

The US is different from other countries that might go on to a IMF program in a lot of ways, but most importantly because it can create the most important store of value in the world, and it can do so whenever it pleases. Ireland, for example, cannot. Neither can Greece or Thailand or Malaysia or even Japan. Gold is limited by quantity, which is why prices are through the roof. Swiss francs are limited by the small size of the Swiss economy and its lack of centrality in the global economic system. The dollar is not only the most-used and most-traded currency in the world, it is also embedded in the global economy in ways that other currencies are not.

The graph above was constructed with BIS data. (Just ignore the isolates like "OtherEMS" and "FRF", which aren't actually in the currency system anymore; I was too lazy to take them out before making the graph.) Node size represents the % of total global currency exchange in a country's currency, and tie thickness represents the (bilateral) size of currency exchange between two currencies. The US is obviously the most central node and is also the largest by far; Swiss francs ("CHF") are much smaller and only has ties to Europe and the US. For the rest of the world shifting out of dollars into the Swiss franc isn't even really an option. For that matter, neither is the euro or yen. Only the US dollar has a truly global reach.

Network externalities can be very powerful. If everyone in the world is using dollars as a medium of exchange, it makes sense for you to use dollars as a medium of exchange. And if you use dollars, then your trading partners and counterparty investors benefit from using dollars. This effect reinforces itself as it spreads through the international economic system. Self-reinforcing patterns are path-dependent in complex networks; it usually takes the destruction of the entire system to reverse them.

And since the US is the only country that can create dollars, it has a very important capability that countries on IMF programs do not: the ability to service its debts with paper, with a strong presumption that it will not be punished for doing so as long as network dynamics remain self-reinforcing. So far the lesson from the S&P downgrade is that those externalities are not only still in effect, but are intensifying.

In other words, the US's peers are not Greece and Ireland, or the countries involved in the 1990s Asian flu. The US's peers are not even France and Germany, which are large industrial countries but do not control the printing press. Nor even Japan, which is sustaining a debt/GDP of nearly 200%. The US has no peers, and this shows up in the bond market data (to be discussed in a future post).

Several times in her post Layna explicitly or implicitly references Barry Eichengreen, who has written a lot on capital, debt, and currency. In a recent column, Eichengreen argues two things. First, that the argument of his recent book Exorbitant Privilege is essentially wrong: the global currency system will not move to a USD/euro condominium in the near term, because "a pox has been cast on both their houses". Second, that there are no other viable alternatives in the form of national currencies -- he explicitly mentions the Swiss franc, Canadian dollar, Chinese RMB, and Australian dollar as being insufficient, despite being the main contenders -- and international baskets like the IMF's SDRs suffer from a lack of liquidity and over-exposure to the USD and euro. So he suggests moving to global GDP-indexed bonds. But this ignores politics. If Europe can't even issue Euro-bonds, and if SDRs are unattractive for a number of reasons, why should we think that a global effort will be more successful?

So I agree with Layna: the era of "exorbitant privilege" is not only not over, but this crisis has seemingly reinforced it. You don't hear much talk about "decoupling" these days.

Catching Up

Apologies for the light posting. I've had fairly severe computer problems that necessitated the purchase of a new one, then an epic struggle with FedEx to actually get the damn thing in my hands. Obviously the past week has been a bad one for an IPE blogger to go missing, but I'm back in business now. So a few rapid-fire thoughts on the week that was.

1. S&P: This is clearly an attack on the US political system, not the fundamentals in the US economy. (The fact that the GOP hasn't internalized this lesson is bad news for them, methinks.) Nothing changed with the US's debt situation, and the solvency of the US is not under question by anyone in the market (more on this in a later post). For this reason the sloppy math in the initial S&P report doesn't matter... it's not about the math. It's about the legislative process. S&P prefers a cleaner one. I guess it's fine to have that preference, which I share but do not expect, but if this downgrade is about political risk than S&P really should have consulted some political risk experts, legislative affairs experts, or political scientists more generally. They also should have talked to folks who study global political economy, since rapping the US's knuckles can have far-reaching effects if done wrongly.

All said, the actual downgrade wasn't too significant, because the US didn't actually default. US bonds are still investment grade, and yields are at historic lows. The credibility of S&P, not the US, is what was severely damaged with this decision.

2. Europe: How long can this go on? The sovereign debt trouble is spilling over into the banking sector more rapidly. The biggest worries now are about Société Générale, and with good reason: it's the second-largest bank in France and the eighth-largest in the eurozone. It was already helped indirectly by the AIG bailout and directly by the Fed's international activities through TAF, but pressures mount and SocGen is definitely systemically important. Tyler Cowen and others have written about the silent bank run in Greece, and how an exit from the eurozone would affect Greek banks, but it would also affect banks in the Euro core.

The ECB is finally starting to act like a central bank, but either way the game has irrevocably changed. As far as I can tell the ECB's current actions are illegal under Article 123 of the Lisbon Treaty, but I'm no EU legal scholar so I could be wrong about that. In any case it seems to me that the eurozone must change somehow. Either by contracting members, dissolving into a two-track union, or centralizing more authority in a federal system.

3. Fed: It now appears clear to me that Ben Bernanke has been hamstrung by a Board that doesn't understand how or why the Fed should be more active. There were three dissents from the most recent, tepid, statement that interest rates would remain low for two years -- a statement that will be interesting to track, as it has credible commitment issues -- and there is no sign of further action. This is a shame. It's also a shame that Obama has left key Fed spots empty for so long. It seems like he'll be nominating Jeremy Stein and Richard Clarida for two empty Board spots, and Daniel Tarullo to the vice-chair spot that heads the regulatory apparatus of the Fed. I'm familiar with Stein's and Tarullo's academic work, and it is very good in both cases.

But this is not enough. The Fed needs to much more active in changing expectations about the path of the nominal economy. It needs to make much more credible commitments to boosting economic activity. It needs to play a greater role in the international banking system to avoid another panic at a crucial time in the "recovery". It, in short, is the most powerful economic agency in the world, and it needs to start acting like it. It has great capabilities, but also great responsibilities.

4. Equity markets: A lot of people are saying that this is like 2008. This is not like 2008. In 2008 credit markets had frozen up entirely, the whole system lacked liquidity, and every major financial institution was in the process of realizing very large losses. That's not the problem today. The problem today is that economic growth has been weak and will remain so for the foreseeable future, and governments are either unwilling (US) or unable (EU) to do much of anything about it. These are the countries that drive global demand, so if they slip up it hurts production in the developing world as well.

Deal?

Looks like there's an emerging debt ceiling deal that will likely pass both houses. Here's the gist:

- Debt ceiling increase of up to $2.8 trillion

- Spending cuts of roughly $1 trillion

- Vote on the Balanced Budget Amendment

- Special committee to recommend cuts of $1.8 trillion (or whatever it takes to add up to the total of the debt ceiling increase)

- Committee must make recommendations before Thanksgiving recess

- If Congress does not approve those cuts by late December, automatic across-the-board cuts go into effect, including cuts to Defense and Medicare.

No new revenues, and the usual "not done deal yet" caveats apply. But assuming it passes this is a huge victory for Republicans. For everyone wondering why they were acting so crazy up until now... this is why they were acting so crazy up until now.

I hope the Fed responds with QE3.

Sometimes Voters Matter

UT-Austin professor of government Sean Theriault makes an important point about the debt ceiling miasma: this is happening because of political audiences, i.e. voters:

In 2005, I published a book called "The Power of the People." In it, I made the simple argument that, contrary to the opinion of a growing number of political pundits, members of Congress are still -- as they have always been -- responsive to their constituents. ...

The general election brought us race after race in which these tea party candidates were running against moderate Democrats, the so-called "Blue Dogs." Some of these Blue Dogs fought against Obama's health care plan. Others fought against cap-and-trade environmental legislation. In fighting these plans, the Blue Dogs frequently made them more moderate.

It didn't matter how hard they fought these plans or that they voted against them because, in November, their constituents voted them out of office. Why? Simply for being Democrats. And because of those decisions in November, the Tea Party Caucus in the House of Representatives now has 60 members -- 60 automatic votes against any type of compromise to preserve the full faith and credit of the United States.

The problem with our deficit crisis today is that the message the voters sent -- and that the winning candidates heard -- was "never compromise, never surrender." We may need such a mentality on the battlefield, but we cannot have such a mentality in politics. Politics, after all, is the art of compromise.

During the Krugman/Crooked Timber fiasco a few months back I tried to make the case that the voters really do play a role in the way politicians act. It's not just elites in the media or business that influence legislators. On this issue all of those groups are on the same side. The Very Serious People universally want a deal done. The rentier class is not interested in a debt default or downgrade, and don't particularly care how it's avoided. And yet here we are. Why? The best explanation has to be that the representatives care about political survival, and their constituents want them to hold the line. For the Republicans, especially those in districts vulnerable to Tea Party mobilization, this means tying a deal to deficit reduction that includes no new tax revenues. And Boehner couldn't unite his own party behind any moderate version of that. McConnell's attempted punt, which would put all of the political heat on Obama, similarly failed. McCain is now calling conservatives in his own party "foolish", "deceiving", and "bizarro". But the Tea Party isn't interested interested in the merely feasible. For the Democrats, it means opposing entitlement reform and especially a balanced budget amendment. This is why Obama went on national television practically begging voters to contact their congresspeople, and then spammed the internet with literally dozens of Tweets passing on the handles of representatives to his millions of followers.

There are a lot of political issues where politics is conducted mainly behind closed doors. The video below describing the experience of Dodd-Frank is one of them. Highly-technical policies are especially prone to "quiet politics". But high-profile political issues like the debt ceiling/deficit battle are anything but quiet, and voters find it fairly easy to take sides. That doesn't mean that voters are perfectly informed -- it seems many have broken the debate down to a more spending/less spending false choice -- but they don't have to be to put a lot of pressure on their representatives.

The Daily Show With Jon Stewart	Mon - Thurs 11p / 10c
Dodd-Frank Update
www.thedailyshow.com
Daily Show Full Episodes Political Humor & Satire Blog The Daily Show on Facebook

Inequality and Fiscal Deficits

A newish paper from Martin Larch at the European Commission's research office:

Fiscal performance and income inequality: Are unequal societies more deficit-prone? Some cross-country evidence

A bias towards running deficits is an entrenched feature of fiscal policy making in most developed economies.

Our paper examines whether this tendency is in any way associated with the personal distribution of income of a country. It takes inspiration from theoretical work according to which distributional conflicts may give rise to deficit spending or to delayed fiscal adjustment. Although these theories have been around for years the empirical literature on the determinants of fiscal performance has so far paid little or no attention to the possible role played by different degrees of income inequality.

Our results suggest that this neglect was not justified. Using cross-country data we find evidence that a more unequal distribution of income can weigh on a country's fiscal performance. These findings can be relevant in the aftermath of the post-2007 global financial and economic crisis in particular when designing fiscal exist strategies. The success and sustainability of such strategies may inter alia depend on their distributional implications.

Score One for the Oatley "Maybe No Big Deal" View

See this Krugman post on Japan's 2002 downgrade.

Wall St. Is Worried About Default, But Still Expects a Deal

CDS on Treasuries have more than doubled in the past two months. And that's not all:

On Wall Street, Treasuries function like a currency, and investors often use these bonds, which are supposed to be virtually fail-proof, as security deposits in their trading in the markets. Now, banks are sifting through their holdings and their customers’ holdings to determine if these security deposits will retain their value. In addition, mutual funds — which own billions of dollars in Treasuries — are working on presentations to persuade their boards that they can hold the bonds even if the government debt is downgraded. And hedge funds are stockpiling cash so they can buy up United States debt if other investors flee. ...

Volatility in stocks has soared, and some investors say stock prices are falling because a United States default could severely raise companies’ costs of doing business.

In the Treasury market, investors are starting to sell, fearing that the government will not make good on some interest payments that will be due next month. And complex financial instruments that will pay out if the United States defaults have become twice as expensive to buy as they were at the start of the year. ...

“The metaphor is a pile of sand,” said Mark Zandi, the chief economist at Moody’s Analytics. “You keep putting one piece of sand on the pile, nothing happens, and then, all of the sudden it just caves.”

I will say that I'm surprised that the market reactions haven't been stronger. I still believe (mostly without evidence) that the markets expect a deal to get down, as do I. As I write this, the top headline on most news websites is that Obama and Boehner are close to a deal, and the markets are up big. Of course I don't want to read too much into that, but look at the betting markets. Right now, Intrade has the chance that Congress passes a deal before midnight on July 31 at only 39%, but the odds that Congress passes a deal before midnight on August 31 at 72%. Remember that the deadline for avoiding default is August 2. So betting markets seem to expect a deal in the 11th hour, which is also what I expect.

I still worry about the trembling hand, however.